International Parity Relations between Albania and Euro Area

Albanian economy is strongly dependent on its trade with Europe and in particular with the Euro area. The paper examines the international transmission mechanisms between Albania and the Euro area, linking its inflation and interest rates with the Euro area ones. The attention is focused on the purchasing power parity, the uncovered interest rate parity, the term spread and the real interest rate parity (Fisher condition parity) analyzing them jointly, within the Vector Error Correction Model (VECM). The cointegrated VAR models are used to define long-run stationary relations as well as common stochastic trends. It emerges that the real interest parity isn't stationary, due to the non-stationarity of the deviations from the PPP condition (ppp term) and that Euro area real interest rates are higher than Albanian real interest rates. An interesting result is that Euro area and Albanian interest rates result as weakly exogeneous within our system of variables, so they could be considered as driving forces for the system, meanwhile the two price inflations result to be “pushed” by the system, in other words prices seem to adjust to deviations from parity conditions. Moreover, permanent shocks to Albanian long-term interest rate seem to have a long-run impact on Albanian inflation. Even Albanian short-term interest rates have a negative long-run impact on the ppp term and on Albanian inflation. Bank of Albania should consider short-term interest rate as an important monetary variable to inflation targeting objective